Sohu Looks Attractive Following Friday's Drop

Two tier-1 firms are out defending Sohu.com (SOHU) this morning:

• Citigroup notes Friday's sell-off was sparked by a Reuters article confirming what almost everyone already knew: Sohu will face challenging YoY comps on its brand advertising side due to a post-Olympics "hangover" effect. However, the firm believes online gaming will continue to power revenue and earnings growth in 2009. It was modeling +18% YoY for 2009 advertising revenues, so the company's expectations of "+20-30% YoY" is actually stronger than its estimates. Finally, they note that online gaming is highly immune from growing inflationary pressures in China, another positive. Accordingly, the firm raises its 2009E estimate, increases its target to $90 (from $80), and reiterates its Buy rating.

2Q tracking is ahead of plan; 3Q looks excellent - Citi believes both Advertising & Gaming are having a strong quarter and should come in above company guidance. 3Q is also set to be very strong, especially with Olympics advertising, which should benefit as Sohu was recently granted the rights to show live streaming video of all events. Sohu is easily one of the, if not the, fundamentally best positioned names for at least the next 2 quarters.

• Merrill Lynch reiterates its Buy and $95 target on Sohu after a massive sell-off on Friday triggered by a report by Reuters on growth of Sohu’s online advertising, 40% of revenues in 1Q08, to slow down to 20-30% YoY in 09. Even given a significant US market correction on Friday, it sees overreaction to the article. The firm also sees Sina (SINA) as another victim.

Merrill Lynch believes the company has been communicating the same message (slowdown in ad growth in 09) for a few months. It also believes the range is inline, if not better, than most analysts’ estimates. For example, it is looking at 22% growth in online ads only, and Bloomberg consensus shows a 23% growth in sales (including games and wireless services).

The firm believes the focus should be on Sohu’s potential margin expansion in 2009, despite lower topline growth. It expects Sohu to obtain a high-tech status and thus a 15% tax rate for 2009. It is also modeling material operating leverage as it expects the reduction in Olympic-related spending next year, estimated to be US$15-20m, to be able to offset most of the increase in operating expenses to support organic growth. It therefore expects net margins to improve to 35% in 09.

Notablecalls: I was quite surprised to see SOHU down over 10 points on Friday following the Reuters story. With two tier-1 firms out defending and one of them actually raising its estimates for Q2, the stock is a very strong bounce candidate. There are clearly a lot of shorts in the name from Friday and I smell blood.

Buy it early & aggressively. I see it trading up several points today.